Business entities, e.g., banks, enter into a large number of transactions in the ordinary course of their operations. Some of these transactions carry financial risks such as currency or foreign exchange (FX) risks, commodity price risks, interest rate risks, stock price risks, and counterparty risks, to name a few. For example, individual loans carry the risk of debtor default, currency exchange rate fluctuations, or changing interest rates for variable rate loans or imminently mature loans (whose principal likely will be reinvested at a new interest rate). Typically, the business entities' internal policies or banking regulations of governing regulatory bodies, e.g., the International Accounting Standards Board (IASB), which has promulgated the International Accounting Standard (IAS) 39, Financial Instruments: Recognition and Measurement, or the Financial Accounting Standards Board (FASB), which has promulgated the Financial Accounting Statement (FAS) 133, Accounting for Derivative Instruments and Hedging Activities, require, at least in some instances, that the business entities own instruments, typically derivatives such as options, whose behavior counterbalances risks presented by the transactions. This is called “hedging.”
Risk exposures presented by a first, typically numerically large, set of instruments are counterbalanced by performance of a second, typically much smaller, set of instruments (called “hedging instruments” herein), such that when risk rises with respect to the instruments that present the risk exposures, risk falls in the hedging instruments. For example, a set of instruments are grouped and treated as a single exposure that is to be hedged. One or more hedging instruments counterbalance the exposure group. The exposures or exposure groups and their corresponding hedging instruments are grouped into corresponding hedging relationships. A hedging relationship associates one or more particular hedging instruments with a particular exposure or exposure group. Accordingly, use of hedging relationships aids in management of risk exposures and corresponding hedging instruments and facilitates compliance with hedging policies or regulations.
Hedging policies or regulations often require that certain exposures be hedged separately, for example, by different hedging instruments, and/or require or allow for grouping of certain exposures into a single group to be hedged by a common hedging instrument or common group of hedging instruments. For example, a business entity often includes numerous departments and/or is often a parent company that has multiple subsidiaries. It is often the case that each or some of the departments and/or subsidiaries individually enter into transactions that create an exposure to risk that is required to be offset by hedging instruments. In some instances, it is left to a central treasury department of the business entity and/or to the parent company to acquire hedging instruments to offset the risk created by transactions of the individual departments and or subsidiaries. Hedging policies or regulations may require that the central treasury department and/or parent company separately hedge against risk of exposures of the individual or certain of the individual departments or subsidiaries.
As another example, an automobile manufacture may wish to hedge against commodity price risks. The manufacturer may, for example, buy raw materials (e.g., steel and brass) with which it builds the products (e.g., cars) it sells. The manufacturer may extract from its business plan the amount of each raw material needed in a given month or quarter. Since those prices, however, may fluctuate, the manufacturer may wish to hedge against the commodity (raw material) price risk. Commodities price risk management may also apply, for example, when buying or selling futures contracts; that is, contracts to buy specific quantities of a good at a specific price for future delivery at a specific time and place.
Businesses may also wish to split risks into their component parts. For example, if brass consisted of 60% copper and 40% zinc, then the price of brass could fluctuate with either the price of copper or the price of zinc. Thus, a car manufacturer may wish to independently hedge against the commodity pricing risks of brass, copper, or zinc. Similarly, the price of a mutual fund may depend on the price of its component stocks. Thus, a broker may wish to split mutual fund risks into manageable and tradable entities.
Moreover, different types of risk may overlap. For example, a car manufacturer in Germany who purchases brass from a supplier in the United States may wish to hedge against both the fluctuating price of brass (commodities price risk) and the fluctuating currency exchange rate (FX risk). Thus, the manufacturer may wish to segregate the commodities price risk and the FX risk to determine appropriate hedging instruments. Again, if the brass were composed of 60% copper and 40% zinc, the manufacturer may wish to further segregate the risks to hedge against each component risk.
A business may also wish to manage the life cycles of risks, for example the cycle of transforming raw materials into income. This cycle may begin, for example, with a plan to buy raw materials (e.g., brass and steel), transform the raw materials into products (e.g., cars), and sell the resulting products. Based on this business plan, the business may secure firm commitments from sellers to provide the raw materials. As the raw materials arrive from the sellers and are paid for, the business's assets and liabilities vary accordingly. As the end products are sold, income is generated, offsetting the liabilities.
Available computer applications aid in the organization and management of a business entity's risk exposures, hedging instruments, and hedging relationships, and generate hedge accounting data, e.g., indicating to what extent the risk of the exposure or exposure group of the hedging relationship is offset by the hedging instrument(s) of the hedging relationship. However, such hedging systems do not provide for automatic grouping of exposures. Further, such risk management systems may have limited capacity and thus not be capable of storing many thousands of entries. In some situations, the central treasury department and/or parent company and the other departments (non-central treasury departments) and/or the subsidiaries do not share the same system. Instead, non-central treasury departments and/or subsidiaries keep track of their individual transactions via separate systems. For the central treasury department and/or the parent company to manage the exposures of the individual transactions and to determine the hedging instruments that must be acquired by using the hedging systems, the data regarding the individual transactions that is already entered into the separate systems of the non-central treasury departments and/or subsidiary companies must be manually entered into the hedging system of the central treasury department and/or parent company.
Hedging systems also provide for associating hedging instruments with an exposure or exposure group via a hedging relationship data object, but, in the past, have required manual entry of data to associate the hedging instruments with the exposure or exposure group.
Thus, a fully integrated solution capable of managing many thousands of entries throughout the product life cycle is required. As production cycles shorten, the need for integration becomes even more important and useful.